Trade Policies, Firm Heterogeneity, and Variable Markups

We study unilateral trade liberalization in the extended model of Melitz and Ottaviano (2008). First, we show that the effect of falling per unit trade costs depends on the use of the "outside good" assumption: in its presence, trade liberalization reduces welfare at Home, and raises it otherwise. Second, we derive the optimal values of import tariffs for the large and small Home economies and show that in both cases protection is a desirable policy. Finally, we look at the role of variable markups and show that in our setting they result in negative pro-competitive effects, reducing gains from trade.